Thursday, December 23, 2010

When investing in a company, it is important to consider the identity of the company's other major owners and creditors. Sometimes other stakeholders have a major effect - positive or negative - on the company's operations. For example, a fellow stakeholder may act as a catalyst, launching a bid for the company or using its position on the board to push for the sale of non-core assets or for the distribution of cash. In other instances, however, the stakeholder can wield its power to the detriment of the company and other shareholders.

Consider the case of Integrated Electrical Services, Inc. (NASDAQ:IESC), a provider of electrical services, including the design, construction, maintenance and servicing of electrical, data communications and utilities systems. I first became interested in IESC when I noticed that it was trading near an all-time low and was approximately 25% below its NCAV (upon closer inspection, the inclusion of operating leases puts the price closer to 10% below NCAV). Since the company was trading so close to its NCAV, I had to consider whether the company's earnings history justified a higher price. Unfortunately, this was not the case, as the company has had a rough time for the last several years, generally unprofitable with sketchy operating cash flows (and scary declines in revenue). Shareholders who purchased in mid-2007 have now seen nearly 90% of their investment dissipate, however one investor in particular has done better for itself than the others. That investor is a private equity firm that owns nearly 60% of the company.

Normally I like when a private equity firm (especially one with activist potential) owns the bulk of a company, as these situations frequently lead to the previously described catalyst events. Unfortunately for IESC's other shareholders, this private equity firm used its control position to benefit itself at the expense of other investors. First, in 2007, IESC repaid a $53m term loan with Eton Park that was just 19 months old and on the same day took out a new $25m term loan with this private equity firm. IESC incurred a $2.1m penalty for doing so and significant legal and other transaction fees. This might be reasonable in a situation where the new term loan is at a much lower rate, but in this case, the rate increased from 10.75% to 11% per annum. So IESC paid a big penalty so that it could pay a higher interest rate (albeit on a lower principal amount) to a large shareholder.

Second, IESC in 2006 purchased $1m worth of EPV Solar Inc. from the private equity firm, then in 2008 extended an additional $2m in a convertible note with warrants to EPV. In 2009 the company restructured the debt, and in 2010 EPV filed for bankruptcy. IESC has now written off the whole thing.

On a side note, IESC has been particularly bad at choosing investments. Rather than simply returning capital to shareholders, the company also invested as a limited partner in another private equity fund and now has associated unrealized losses. This is a red flag for value investors as companies that engage in empire building reduce the likelihood of the investor receiving capital via a dividend or share repurchase (since the company is busy engaging in empire building), and so the only return to the shareholder will be in the form of capital appreciation. In the case of empire builders, it is difficult to rely on capital appreciate as the sole return because the investor must be confident in the company's ability to successfully operate in its core area (in this case, electrical servicing) and the unrelated empire areas (in this case, private equity and start-up investments - areas the company had no expertise in!).

The lesson is that it is important to understand who you are investing alongside. The presence of a majority shareholder skews the power structure and incentives for everyone involved.